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The route to reflation

Governments and central banks around the world are trying to boost demand and minimise the risk of an extended and damaging period of deflation but the first half of this year is clearly proving to be extremely difficult.

However, as we move into the second half, we hope to see the first signs that the reflation packages are gaining traction. We predict the economy will stay in recession all through 2009 and into the early part of 2010 but we are not in the Armageddon camp and prefer to call this event a serious recession rather than anything more sinister.

Given that corporate profitability was generally healthy before the credit crunch began, we think it is would be reasonable to assume that, from peak to trough, UK aggregate corporate earnings will fall by more than in past recessions , perhaps by as much as 50 per cent. With the FTSE 100 at less than 4,000, and on a price/earnings ratio of around eight, we think that the market is already fully pricing in the serious recession scenario.

On their own, very low valuations are often not enough to tempt investors back into equities but at some point, pessimism will begin to ease.

We think gilts look pretty fully priced at current levels and we have cut our exposure to zero. We like high-quality investment-grade corporate bonds, which are offering a yield of more than 5 per cent above gilts. This should be enough to overpower the negative trend of increasing downgrades and defaults.

We expect commercial property values in the UK to fall further over the coming months as valuers continue their effort to catch up with the pricing evidence gleaned from the limited number of transactions going through.

The weak economy, rental pressure and increased bankruptcies among tenants are unhelpful factors but the biggest problem is the level of distressed selling.

Nevertheless, there are potential buyers about and we anticipate transactions will start to pick up in the first half of 2009. We anticipate growing interest from overseas players, in part, because the UK commercial property market remains transparent. The weak pound only adds to the appeal of pricing levels.

On currencies, our key view is that it seems that sterling looks oversold, especially against the euro. The euro has gained support as a reserve currency but we doubt that the market will ignore the economic strains and stresses that are now very apparent. Therefore, we believe the chances of the euro weakening against the pound are relatively high.

There is no doubt that the current environment is difficult. Investors are faced with the conflicting signals of extremely low valuations for financial risk assets but also risks and uncertainties.

It is probably a mug’s game trying to guess where the market is going in the short term. However, for those that can live with the risk of being early and have a genuine longer-term mindset, we believe that the turmoil has thrown up some very interesting investment opportunities.

Andrew Yeadon is head of multi-manager at Schroders

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